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Momentum : A Cinderella Story

Featured in the Georgia Association of Public Pension Trustee’s Quarterly Publication in July, 2021.

 

It is not often that you get to compare investment concepts with a Disney movie, but when it comes to Momentum strategies, a Cinderella story comes to mind. Since its academic discovery in 1993, Momentum investing has received little praise from the investing community despite posting impressively consistent outperformance relative to other commonly used factors (e.g., Value and Size). MSCI’s most recent Factor Focus paper on Momentum highlights how, “on a historical basis, the momentum factor has been one of the strongest generators of excess returns”¹. With another good year under its belt and increasing levels of asset flows (the largest Momentum ETF by AUM, iShares Edge MSCI USA Momentum Factor ETF, saw a net inflow of over $1 billion in 2020 and has experienced a net increase of almost $8 billion in asset fund flows over the last 5 years), it looks like Momentum has met its Prince Charming and is finally getting the chance to attend the big ball.

A Background on Momentum

Originally discovered in 1993, the general theory behind Momentum investing is best described by Sir Isaac Newton’s first law of motion: an object at rest stays at rest while an object in motion stays in motion unless acted upon by an external force. In the context of financial markets, stocks that have done well recently will continue to do well and stocks that have done poorly will continue to do poorly until a catalyst changes this dynamic. A Momentum-based investment philosophy is inherently logical, and – as we will highlight later in this piece – has been proven to provide value. However, the theory that stocks which have increased in price will continue to increase because of the recent price action challenges the traditional approach to investing that uses company fundamentals to make investment decisions.

How Momentum Works

The research published by the Journal of Finance 1993 documented how strategies of buying recent stock winners and selling recent losers generated significantly higher near-term returns than the U.S. market overall from 1965 to 1989². Although the markets look very different than they did in 1989, the argument can be made that the research completed in 1993 is more relevant now than ever. Depicted in Figure 1 is a graph that demonstrates the growth of $100 invested in the S&P 500 Momentum index in 1994 (the first year the index was established) compared to $100 invested into the traditional S&P 500 index. The S&P Momentum index measures the securities that were among the 100 best performing securities over the past 12 months and weights these securities based on their market capitalizations.

past performance is not indicative of future results

Since 1994, the S&P 500 Momentum index has outperformed the S&P 500 index on an annual basis by over 1.2% and has provided an annualized return of 11.9% compared to 10.7% provided by the S&P 500 index. Over this same time period, the annualized standard deviation of the S&P 500 Momentum index has been 20.9% compared to 19.1% for the S&P 500 index. Although the Momentum index has been more volatile than the S&P 500, outpacing the S&P 500 over the past 30 years is still an impressive feat. So, why are investors still hesitant to adopt Momentum-based strategies?

Unlike a traditional investment process where an investor assesses a company’s fundamentals, creates a price target, and makes and investment decision, Momentum strategies lack the quantitative rationale that traditional investors rely on. Instead of being quantitative in nature, the rationale behind why Momentum works is a result of investor behavior. Investors are constantly reacting to the information available to them, leading stock prices to trend in a specific direction for longer periods of time with greater magnitude. Furthermore, the rapid growth of technology in the last 20 years has led to an unprecedented increase in information and access to markets for all investors. Technology is certainly not going away and advancements are not expected to slow down. Thus, the argument could be made that the overreactions and underreactions of investors will continue to grow, suggesting that the performance of Momentum strategies has even more of a catalyst to outperform in the future.

Looking beyond why the strategy works, investors should be aware that Momentum is not a sufficient risk management tool. As illustrated in Figure 2, Momentum strategies are not protection during steep market corrections like 2000, 2008 and 2020. The track records during these periods show mixed results. In 2000, a U.S.-based Momentum strategy, represented by the S&P 500 Momentum index, underperformed the S&P 500 index. However, the MSCI ACWI Momentum index outperformed the MSCI ACWI index during the same time period. In 2008, these results flip-flopped and in 2020, Momentum strategies outperformed both the S&P 500 index and the MSCI ACWI index.

past performance is not indicative of future results

The key lesson for investors is that while Momentum has been proven to provide value over time, the strategy alone is not a sufficient risk management tool to avoid major bear markets or crashes. At Balentine, we believe proper risk management can be achieved through the combination of Momentum and Relative Value. A strategy that combines both Relative Value and Momentum is represented by the Balentine GTAA Aggressive strategy in Figure 2. It is important to note that while most investors think of Relative Value as undervalued securities, Balentine measures Relative Value as the valuation of equities relative to fixed income. As indicated in figure 2, the combination of Relative Value and Momentum has allowed our strategies to avoid extended bear markets for the last two decades. While the coronavirus crash was not a sustained bear market, our Momentum-based strategy put us in the correct asset classes allowing our strategy to outperform.

How to Use Momentum

As mentioned earlier, strategies focused exclusively on security-level Momentum can be more volatile during crashes and could potentially increase the risk profile of the portfolio. Figure 3 shows the annualized gross return of the MSCI ACWI index compared to the MSCI ACWI Momentum index during the Great Financial Crisis. The MSCI ACWI Momentum index underperformed the MSCI ACWI index by 2.4% in this 17-month period, highlighting the potential underperformance of Momentum strategies during bear markets.

past performance is not indicative of future results

Figure 3 also demonstrates the value of using Momentum on an asset class level instead of looking at individual securities. The potential value-add of this approach is illustrated by Balentine’s Equity Momentum performance during the Great Financial Crisis in Figure 3. While the drawdown during this time period is significant, the Equity Momentum Model was able to outperform the MSCI ACWI Momentum index by almost 2% and provided similar returns the MSCI ACWI index.

This is further illustrated by Balentine’s outperformance during the coronavirus crash in 2020 (Figure 4). The speed of the market decline and recovery during the coronavirus crash made it unique and led to the Momentum index outperforming the MSCI ACWI index during the 3-month period. Balentine’s Equity Momentum Models were able to further capitalize on this phenomenon by outperforming both the MSCI ACWI index and the MSCI ACWI Momentum index.

past performance is not indicative of future results

Implementing Momentum on an asset class-level not only improves performance during crashes, but also provides value over a full market cycle. The value-add of a Momentum-based strategy implemented on an asset class-level is demonstrated in Figure 5. This graphic illustrates how Balentine’s Equity Momentum Model, which is implemented on an asset class-level, has provided value to our investors relative to a global equity benchmark. For an investor looking to benefit from the capabilities of Momentum while also being conscious of volatility, a Momentum-based strategy that is implemented on an asset class level might be the most effective option.

past performance is not indicative of future results

Closing

No matter the style of Momentum-based strategy an investor chooses to implement, the most important learning outcome from this piece is the realization that Momentum is an effective and well-established investment style that could add value to a portfolio. We would like to leave readers with 4 key take-aways:

  1. Momentum has gotten very little respect from investors despite academic research and consistent evidence in the form of returns.
  2. Since its discovery, the Momentum factor has identified persistent market inefficiencies at a security and asset class-level within equities.
  3. Combining Momentum with Relative Value gives investors the potential to dampen exposure to sustained bear markets while still having the opportunity to make rotation into segments of the market that are experiencing strong Momentum.
  4. This is what we do at Balentine – we pay attention to academic research and evidence – we have a data driven approach, capitalizing on human behavior with a track record of providing value to investors.

As you are considering potential allocations changes this year, we implore you to consider a Momentum-based strategy and “if the shoe fits,” do not be afraid to add it to the portfolio.


¹https://www.msci.com/documents/1296102/8473352/Momentum-brochure.pdf

²http://www.business.unr.edu/faculty/liuc/files/BADM742/Jegadeesh_Titman_1993.pdf


BALENTINE LLC

GLOBAL TACTICAL ASSET ALLOCATION (GTAA) AGGRESSIVE COMPOSITE

ANNUAL DISCLOSURE PRESENTATION

Global Tactical Asset Allocation (GTAA) Aggressive Composite: The Global Tactical Asset Allocation (GTAA) Aggressive Composite utilizes public markets and does not have private capital. This strategy aims to return inflation plus 4% over a rolling 7-year period and invests 100% in global equity. This strategy tactically shifts in and out of asset classes across a global opportunity set. The track record prior to 1/1/2019 represents that of the Global Asset Allocation Aggressive Composite (“GAA Aggressive”), which utilizes public markets and does not have private capital. GAA Aggressive aimed to return inflation plus 4% over a rolling 7-year period and invests 100% in global equity. The composite is compared against the MSCI ACWI (Gross). The minimum account size for this composite is $100,000. The Global Tactical Asset Allocation (GTAA) Aggressive Composite was created January 2019.

Balentine LLC (“Balentine”) is a registered investment adviser with United States Securities and Exchange Commission in accordance with the Investment Advisers Act of 1940. The firm’s full list of composite descriptions is available upon request.

Balentine claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Balentine has been independently verified for the periods March 1, 2010 through December 31, 2018.

Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. The verification reports are available upon request.

Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Past performance is not indicative of future results.

The U.S. Dollar is the currency used to express performance.  Returns are presented gross and net of management fees and include the reinvestment of all income.  Net of fee performance was calculated using a model fee of 1.25%, the model fee includes all management fees. The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in the composite the entire year.  Policies for valuing portfolios, calculating performance, and preparing compliant presentations are available upon request. Composite policy requires the temporary removal of any portfolio incurring a client initiated significant cash inflow or outflow of at least 10% of portfolio assets.  Additional information regarding the treatment of significant cash flows is available upon request.

The investment management fee schedule for the composite is tiered at: first $5mil 1.00%, next $10mil 0.60%, next $10mil 0.50%, next $25mil 0.35%, next $25mil 0.25%, next $25mil 0.20%, next $150mil 0.15% and over $250mil 0.10%. Balentine, in its sole discretion, may consider clients below $5mil as follows: $0-$2.5mil 1.25% and next $2.5 0.75%. Actual investment advisory fees incurred by clients are negotiable and may vary.

Important Note Regarding Net-of-Fee Returns

Net-of-fee returns were calculated using the highest fee paid by any client, which is 1.25%. If net-of-fee returns were presented based on actual management fees charged, the results would be higher.

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